Expectational business cycles

I introduce Expectational Business Cycles where aggregate activity fluctuates due to learning, heterogeneous updating rules and random changes in the social norm predictor. Agents use one of two updating rules to learn the equilibrium values while heterogeneity is dictated via an evolutionary process. Uncertainty of a new equilibrium, due to a shock to the structure of the economy, results in a sudden decrease in output. As agents learn the equilibrium, output slowly increases to its equilibrium value. These business cycles arrive faster, are longer and more severe as agents possess less rationality.

Introduction: Uncertainty affects the daily decisions we make in our lives for if we knew all our future lifetime events, we would certainly change our behavior in order to maximize actual total lifetime utility. Unfortunately, we are uncertain about events that affect our lives, the world and the economy in both the micro and macro levels. This uncertainty affects each individual’s behavior of consumption, investment, and employment. Better expectation mechanisms can lead to smaller forecasting mistakes and less uncertainty and thus lead to higher current and future benefits.

Author: Eran Guse

Source: Research Discussion Papers, Bank of Finland

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